The TSC Streetside Chat: Vanguard Founder John Bogle

The democratization of the stock market owes much to John Bogle, founder and former chairman of The Vanguard Group. The pioneer of low-cost index investing has been a powerful advocate for individual investors over the years and is still preaching his mantra of inexpensive, efficient mutual funds for investors of all backgrounds and income levels.

His new book, John Bogle on Investing: The First 50 Years is a compilation of Bogle's writings on the mutual fund industry over the last 50 years. TheStreet.com's Catherine Valenti recently sat down for a chat about the mutual fund industry and the markets with Bogle, who now serves Vanguard in an advisory capacity. His zeal in the crusade for the average investor has not waned.

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Catherine Valenti: What compelled you to come out with this book? Was there any catalyst to release the book now?

John Bogle: Well, there actually was. Last December, Jeff Cranes, the business books publisher at McGraw Hill, came to visit me and told me that the company was planning to do a series called Great Ideas in Finance. They wanted me to do the first volume.

And I said that's great, Jeff, but I can't write anymore. I just finished a book eight or nine months ago. He said this won't require too much because we want to do a collection of your speeches -- and we want to print your Princeton thesis as the beginning of the great ideas.

And I said, Hmm, maybe I better read the thesis first. And it happened to be 50 years, almost to the day, from the time I opened Fortune Magazine, December 1949, and read an article entitled "Big Money in Boston." That was the inspiration for my senior thesis at Princeton.

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So I thought, Well, you know, it's sort of fun to think of something being published 50 years later. I thought about it for a week or two, and looked at some of the old speeches that I had -- well, I've kept them all over the years and there must have been about 100 -- and I decided it would be worth giving it a shot.

Catherine Valenti: What, in your estimation, have been some of the biggest changes in investing in the past 50 years?

John Bogle: Well, first of all, the world of investing has changed unbelievably. Public interest in equity has gone right through the roof.

There were three business magazines then, we probably have 33 now. There certainly wasn't a television station devoted to business news; now we probably have, counting the cable channels, half a dozen in which business news is very important.

Trading on the New York Stock Exchange was 2,000,000 shares a day, now it's 2,000,000 shares a minute. The mutual fund industry back then was about a $2.5 billion industry, now it's $7.5 trillion.

So things have gotten bigger, trading has gotten much more active. Then, the turnover in the stock exchange was probably in the area of 18%. Now it's about 90%-95% and the turnover of the Nasdaq is around 275% or something like that.

Catherine Valenti: What do you see as the consequences of these changes -- positive and negative?

John Bogle: With respect to the mutual fund industry, it was a much different then, and in many respects, much better.

Costs were much lower, the expense ratio for the average fund was about 0.78% in 1950 and now it's 1.61%, about twice as high. And fund turnover then was 15%-20%, now it's 90% -- a huge increase and a change really from a long-term investment to short-term speculation.

Funds, in the earlier era, went out of business at the rate of about 1.5% a year, meaning 15% in the '50s. And in the decade of the '90s, they went out of business at about a 5.5% annual rate, meaning that 55% of the funds that were in business during the '90s are no longer here.

Fund investors held their shares for an average of about 12.5 years back then. Now, according to the latest data, the average holding period is only about a little over two years.

Assets have gotten bigger, the speed of transactions has gotten bigger and the cost of investing has gotten bigger in the fund business. I think those are all big negatives and I think this industry should really be moving around to find its way.

Catherine Valenti: What can be done about that?

John Bogle: Well, the answer is not very much. There's apparently very little we can do.

Sooner or later, like a political situation, the answer has to be found in the votes of investors. And when investors get some wisdom about what's going on, they will start to vote with their feet. That is a vote that, believe me, fund management companies will have to listen to.

Second thing is, I think it would be good if the Securities and Exchange Commission spoke out from its bully pulpit a bit more vigorously on the subject of management fees and less profitability in this business for managers. Chairman [Arthur] Levitt is doing a good job in that area. Reading his speech at the Securities Industry Association in Florida, he mentions it very importantly -- the huge impact mutual fund costs have over the long term. He happened to be kind enough to quote some work I've been doing on the impact of costs on long-term returns, and they're devastating.

I also think it's up to fund directors to stand up and be counted. They don't work for the fund manager, they work for the fund's shareholders. And whether that wake up will take place through litigation, which has not been particularly successful, or some other means, I don't know. But ultimately, these things rest in the hands of the investors.

By the way, one thing that will awaken investors to what's going on is a period of lower returns. I mean, there's no question the way the world will turn, but it's going to be up to investors to wake themselves up. "The mutual fund industry back then was about a $2.5 billion industry, now it's $7.5 trillion."

Catherine Valenti: You're a pioneer in index funds. Briefly explain that concept and why you think it works so well.

John Bogle: Sure. In essence, indexing is owning the entire stock market and holding it forever. Owning every corporation in America in proportion to its market capitalization, and never selling. That's what indexing is all about. It has no value at all, unless it's offered at a very low operating cost, and very low transaction costs. Portfolio transactions should be very, very limited and should hardly detract from the long-term return.

So the idea of indexing is essentially to get as close to 100% of the stock market's return as is realistically possible, and that is to say, get 98% or 99% of the market's annual return.

What makes it valuable is that the average mutual fund gives you 75% of the market's return -- so, in a 10% market, with approximately 2.5% costs in this industry, you get 7.5%, which is 75%.

So the odds are that you'll get 75% of the market's annual return and you know it's a certainty that you can get -- that's pretax -- 98% or 99% of the market's pretax return through an index fund.

Catherine Valenti: Some critics would argue that it's been a stock picker's market lately, and this year we've seen some outflows from index funds. What argument can you make to investors for staying put?

John Bogle: First of all, there's no such thing as a stock picker's market. Because all the stock pickers together by definition get average returns. And if some of them get above average returns, it would follow that others must get below average returns. So what may look like a stock picker's market, simply by definition, cannot be.

That's not to say that somebody who picked value stocks this year wouldn't have done very well, but you must understand that somebody else is holding those growth stocks, and not doing well. So a very good stock picker has to be offset by a very bad stock picker, because you can't have both of them performing above the average of the market.

Indexing works and it works precisely in that statistics don't always convey what common sense makes clear. Mutual funds -- that's the usual universe we rate indexing against -- come in different sizes, different shapes, they own different kinds of companies. If there are a great many small-cap companies, for example, in a small-cap year, the large-cap index wouldn't have a chance, but it's still beating the market, which is dominated by large-cap funds.

Indexing always works -- that's the most important thing to realize -- although it may not always look like it works. And the nature of this is that this year, as it happens, indexing is looking somewhat worse than it really is. But for two or three years in the late '90s, and I said this, at the time, very clearly, indexing was looking better than it really is, because it was a big-cap market -- the S&P 500 -- therefore it did better than the average mutual fund, many of which were small-cap in orientation.

So the numbers can deceive. And we shouldn't have been deceived then. Nor should we fool ourselves now by thinking it's worse. The index is going to do just fine. And I might say that during the first three years of the history of the Vanguard Index Trust, or the (VFINX Quote)Vanguard 500 Fund as it's now called, which was in 1977-79, the index outperformed about 25% of all managers.

It looked just about like it does today, but that didn't bother me then and it doesn't bother me now. These things will all even out over the long run.

I should say, by the way, that I started the definition of indexing as the ownership of the entire market. It sounds like a big transaction, but it's not because you do exactly that by owning an all-stock market index fund. And S&P 500 fund, I want to put aside any idea that there's a big difference between the 500 and the total stock market, because the 500, while it's only large-cap stocks, is about 75% of the value of the market.

So the S&P 500 is a very good proxy. While it doesn't own small- and mid-cap stocks, over time, when you look at the years when small- and mid-cap do better and the years when they do worse, the return on the S&P 500 should be almost identical to the return on the total stock market, and in fact that's been exactly the case, precisely the case, in the 30 years since we had the total stock market index. The indexes, the S&P and the total stock markets have performed identically. "Indexing always works -- that's the most important thing to realize -- although it may not always look like it works."

Catherine Valenti: We now have a lot of other mutual fund companies jumping on the index fund bandwagon and getting into exchange-traded funds. How is Vanguard trying to distinguish itself among all of the products that are offered out there?

John Bogle: Well, I think we should just stay the course in the strategy that we followed from the very outset. Which is, we know what we can do, we know how to do it. Our largest portion of assets here are index funds -- not all, but most. Most of the other funds are run on very much indexing-type principles, which is low cost, very broad diversification, high-quality security, low trading and very little guessing at what the future holds.

And that's an extremely important thing for us to do for as long as this company exists. If people want to come in and say, well here's some trick fund indexing where you can trade a lot, that will come and go. But anyone that wants to use an index as a trading vehicle ... as the ads for the Spider [Standard & Poor's Depositary Receipts, State Street's exchange-traded fund that tracks the S&P 500] say, trade in real time throughout the day. No question that's true, and no question it's great value, and there's no question it's a stupid strategy.

Catherine Valenti: And you say that Vanguard is entering the ETF market.

John Bogle: Well, our idea is, apparently, to have the trader in the index funds get out of the regular trading fund and into the Spiders, where the other shareholders in the fund will be insulated from the trading.

Catherine Valenti: So how will its low-cost, buy-and-hold philosophy be reconciled with offering an ETF at the same time?

John Bogle: Our ETF, called Vipers, will be very low cost. So that's fine. I'm going to have to leave it to wiser heads to tell me how you can reconcile that with a long-term strategy.

The Viper will be an expert investment for long-term investors. It won't be any better than the index fund itself in my judgment, and I have most of my holdings and all of my taxable holdings in index funds here, and I'm not switching over. Because I don't think it has any marginal advantage.

Catherine Valenti:I know that Standard & Poor's is seeking to block Vanguard's launch of the new Viper exchange-traded funds because of licensing disputes. Can you talk about how you think that situation might be resolved and how it might affect Vanguard's plans to roll out new ETFs in the future?

John Bogle: I don't follow the day-to-day management here, so I'd have to defer that to those who are closer to it than I am.

Catherine Valenti: Sure. Let's get back to the low-cost theme of Vanguard's mutual funds. The company prides itself on that but I know that as of mid-October some Vanguard funds had some estimated capital-gains distribution that were pretty high, one -- (VEXPX Quote)Vanguard Explorer -- as high as 19%. Can you talk about what you think accounts for some of those high distributions?

John Bogle: Portfolio turnover is the main thing in active funds, although our portfolio turnover is much less than the industry. You have active turnover at a very high point in the market, particularly earlier this year, and you realize gains.

I think it raises a question about the extent to which actively managed funds serve the needs of taxable investors. But it's raised that question for everybody, forever.

Explorer is 18% at the moment. But this has been a small-cap fund; it has a reasonable amount of turnover, fairly low turnover compared with other small-cap funds. But if you keep your turnover low at the beginning, when you have some turnover later on, you've got much more highly appreciated securities.

So that fund has paid out an awful lot of its accumulated realized gains and will have a net of that at only a 10% unrealized gain. So that the protection of having realized the gains this year, the protection for shareholders in the future, will be much greater.

Tax effectiveness is a very perverse concept because it must be clear that the more tax effective you are in the past, the greater the risk that you'll generate a lot of gains in the future.

I mean, if there are two funds similarly situated and one realizes all its gains every year and the other doesn't, one will end up with, for the purposes of argument, no realized capital gains for the end of the period, and the other, let's say, will end up with maybe 100%, let's say 70% of the asset value in the form of unrealized gains. So the tax effectiveness gives you a bigger unrealized appreciation on your books. "If you can't imagine a 20% loss in the stock market, you really shouldn't be in stocks."

Catherine Valenti: Let's shift gears to what's been happening lately. What do you think of the stock market's valuation now, and where do you see the market going over the next year or so?

John Bogle: Well, nobody really knows how to make short-term swings in the market. I work off the projection I did -- not really a forecast -- as the year 2000 began, looking ahead to returns in the 10 years ahead, and I tried to point out to people that it's relatively easy to forecast the investment return on stocks, the earnings and dividends.

We're starting off this new decade with a 1% dividend yield -- very, very low -- and not a lot of support for the market. If I were to assume 8% earnings growth, that would give an investment return on the market -- a fundamental part of the market return, the real return, the substance -- of 9%. Now, that's exactly what the market return will turn out to be in this decade, assuming we have those numbers.

Exactly the same, the market return will be the same as the investment return if stocks continue to sell at 30 times earnings. And whether that 30 goes to 40, or down to 20, or any other number is a matter of speculation, and we call it the speculative return. Because a change in the P/E ratio from 30 to 20 over the next decade, say, would reduce the value of those earnings by 33%, it would cut the value of the market by 33%. And that actually would take off about 4 percentage points per year from the market's returns.

We'd be looking at a 5% return on stocks in the coming decade, which is kind of my number. And I feel very good about the first half, the investment return half, but I have no more knowledge than anybody else of the second.

I may be too optimistic because the market may sell at 16 times. It's sold less than that many, many times in the past. So that's not a gory negative prediction. So if we look at the 10 years, what's going to happen in the earlier part of that period is essentially what your question is, and while the answer is clearly "I don't know," it's equally clear that if the market's going to give us 5% a year, it's not going to give us 5, 5, 5, 5,5,5,5 -- we know that as a fact.

I would guess that we'd get a pretty good bump, and of course we've had a pretty good bump. Since mid-March when I put these numbers together, or since January, the market's sold about 10%.

But I would guess there's probably another good bump in the market. This one has not been very serious at all, in spite of what I read in the various news articles and that kind of thing. It's been serious in the Nasdaq, there's no question about that -- it's off more than 40% from its March high. It's down about 20% for the year, and that's serious, but not irreparable.

If you can't imagine a 20% loss in the stock market, you really shouldn't be in stocks. We haven't seen very much so far, but I think I'm doing pretty good almost a year after I made that projection, with where we are today.

Catherine Valenti: Do you think that investors should be concerned about the uncertainty over the election? Do you have any thoughts about how the outcome might affect investors or the market?

John Bogle: I don't think it will affect investment returns one iota. I would be astonished if the differences, in a realistic world, between the parties, matter.

I was giving a speech on the subject recently and I pointed out a couple of things. One, under Democratic administrations in the last 50 years, the growth in GDP, economic growth if you will, has been 50% higher than under the Republicans, and the return on the stock market has been 50% higher under the Democrats than under the Republicans, as it happened.

I told this group that would be very, very important information if the stock market were an actuarial table, but I assured them it was not. And if you look at divided government, if a Republican is in charge of it, the returns on the market in the next two years in the Dow are about 10%, not very good for a two-year return. In a study -- this is going back to 1896 now -- the returns under a Democratic president and a Republican or a divided Congress, were 18%. So, if we believe in all this actuarial stuff, we ought to be rooting for Gore

Now, I happen to think that's a whole lot of statistical noise. I'm unable to predict how the speculative part of the market will react to this uncertainty. But for a long-term investor, what is this going to mean a year from now? Ten years from now?

The fact that there was a little fight or squabble over who was going to be the president when both presidents are more or less centrist, and in the obvious situation we have in Washington, and that is a very, very much divided government. Even though, if Bush were to win, we would obviously have a Republican Senate or a Republican House or a Republican Congress, a Republican house of Representatives and a Republican Senate, those margins would be so narrow that I don't think anything drastic would be done. And I think that's good. I don't think we need a lot of drastic things done.

Catherine Valenti: Right. Do you subscribe to the argument that certain sectors will benefit from a Bush presidency, like pharmaceuticals, for example, or defense?

John Bogle: Oh, I accept that. Pharmaceuticals, defense, oil would certainly benefit, and those kinds of things. But, you know, the market is not stupid, the stock market is the greatest arbitrage medium ever designed by the mind of man. And I think that, call it the Bush effect is in the market in a marginal way. If Gore ends up being elected, I would guess those kinds of stocks would be weak, but in a marginal way. And I wouldn't have a clue as to how to trade that. It just doesn't pay.

Catherine Valenti: Exactly. So your advice for investors is...

John Bogle: Stay the course.